You refer back to your previous post on NGDP level targeting, but fail to take note of the comments that respond to your concerns about it. Specifically, see the ones by Andy Harless and Gregor Bush. Would love to see your response to those ones. Do you have a response for them? I am listening if you have one.

Here is an excerpt from the Harless comment...

Most people who advocate NGDP targeting today advocate level path targeting, not growth rate targeting. I don't believe that your "historical justification" applies in this case. Indeed, I think it makes the case for level targeting (of either the price level or NGDP, but there are reasons to prefer the latter) relative to the current system which centers on a growth rate target for the price level (in other words, an inflation target).

...and here is the Bush comment:

Just to add to Andy's point, advocates of NGDP level targeting argue that it's precisely because of uncertainty around estimates [of] potential output [that] NGDP targeting should be adopted. They argue that [as] long as the central bank keeps nominal spending on, say, a 5% trend line, there will be neither demand side recessions (mass unemployment) nor high inflation. In other words, AD will be stable and this will produce a stable macroeconomic environment. Whether inflation is 2% and real output [grows] at 3% or inflation is 3% and real output grows at 2% is of no concern.

In the post on NGDP targeting I was in fact thinking about level targeting, and Gregor Bush's last sentence gets to—in fact is—the heart of our disagreement. I am just not willing to concede that anchoring long-term inflation by saying something like "2 percent, 3 percent, whatever" is the path to sustaining central bank credibility. Over the longer term, inflation is the only thing that monetary policy can reliably deliver, as the Federal Open Market Committee (FOMC) has clearly articulated in its statement of longer-run goals and policy strategy:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate...

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision.

This excerpt does not imply, of course, that the Fed need slavishly pursue a numerical inflation target in the shorter run and, as I have pointed out before, in his last press conference Chairman Bernanke explicitly indicated that the FOMC does not intend to do so:

The Committee... intends to look through purely transitory fluctuations in inflation, such as those induced by short-term variations in the prices of internationally traded commodities, and to focus instead on the underlying inflation trend.

My price-level targeting post, co-authored with Mike Bryan, was exactly making the point that, over the past couple of decades, the FOMC has essentially delivered on a 2 percent longer-term price-level growth objective, while accepting plenty of shorter-term variability.

In the end, it is an open question whether credibility in delivering price stability, hard won in the '80s and early '90s, could be sustained if the FOMC says it does not care so much about the exact level of the average rate of inflation, even in the long run. To be truthful, I can't give you an answer to that question. But neither can the proponents of NGDP targeting. I just don't feel that this is an opportune time for an experiment.

Comments

"I am just not willing to concede that anchoring long-term inflation by saying something like "2 percent, 3 percent, whatever" is the path to sustaining central bank credibility. Over the longer term, inflation is the only thing that monetary policy can reliably deliver, as the Federal Open Market Committee (FOMC) has clearly articulated in its statement of longer-run goals and policy strategy:..."

Presumably the damning part of the FOMC statement is the following portion:

"...The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision..."

This might be relevant if nominal GDP (NGDP) level targeting were indeed "specifying a fixed goal for employment." But NGDP level targeting is not specifying a fixed goal for employment. Rather it is specifying a fixed goal for NGDP.

The only thing that the Fed can reliably target are nominal variables, such as inflation and NGDP.

But one very significant problem with targeting inflation is that it is a totally artificial construct requiring that we come up with an estimate of the extraordinary abstraction known as the "aggregate price level." To see how preposterous this is imagine equating the aggregate price level between what it is now and what it was in say 14th century England. The goods and services are so different it requires the complete suspension of one's disbelief.

Inflation is the difference between NGDP and real GDP (RGDP), meaning inflation is nothing more than the estimated residual between a nominal variable, which is relatively straight forward to measure, and a real variable, which is fundamentally an exercise in crude approximation.

Thanks David,
I appreciate your response. I have to disagree with this statement though:

“I am just not willing to concede that anchoring long-term inflation by saying something like "2 percent, 3 percent, whatever" is the path to sustaining central bank credibility. Over the longer term, inflation is the only thing that monetary policy can reliably deliver, as the Federal Open Market Committee (FOMC) has clearly articulated in its statement of longer-run goals and policy strategy.”

I don’t think that’s correct. It’s true that monetary policy can’t target real variables in the long run. But it can certainly target any nominal variable that it wants to. The Hong Kong Monetary authority has targeted an exchange rate of 7.75 HKD per USD for almost 30 years and it has been completely successful in doing so. Inflation over that period of time has fluctuated substantially, reaching a high of +12% in 1991 to a low of -6% in 1999. Over that 30 year period, Hong Kong inflation has averaged about 1.3 percentage points above US inflation. Does all of this mean that the HKMA has no credibility? Of course not. It has been and continues to be completely credible with respect to the chosen target. Now, we could argue whether Hong Kong might be better severed if it targeted 2% CPI inflation rather than the nominal USD exchange rate (I think it would be). But that’s an argument over which comes closer to the socially optimal target, not over which target would give the central bank more credibility.

We could make a similar argue with the Bank of England successfully targeting the nominal price of gold in the 1871 to the 1914 period. So I see no reason why the Fed couldn’t target nominal GDP and be completely credible with respect to its NGDP target. If Congress instructed the Fed to switch to an NGDP level target would you bet against the FOMC hitting it?

“I just don't feel that this is an opportune time for an experiment.”

Here again, I disagree. I think it’s an excellent time. The only better time would have been January of 2009. The performance of the economy over the past 5 years has been an unmitigated disaster. And the “hard won battles” of the early 1980s and 1990s weren’t enough to prevent it. It turns out that anchoring inflation expectations at 2% is not enough to prevent a massive and sustained shortfall in aggregate demand. In 2007, I thought that a 2% inflation target ruled out the possibility of a recession of this magnitude. But I was wrong.

Thanks David for taking the time to reply. I have been meaning to respond, but as you note Scott already has. I would also encourage you to take a look at Scott's piece in the FT Alphaville where he engages in a similar discussion:

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January 10, 2013

Visualizing Improvement

"In short, not especially strong nor weak. While a 150–170K per month trend in payrolls is far from booming, it is strong enough over time to keep the unemployment rate moving down given slowing in the secular trend in labor force growth. Unemployment was flat in December, but it is down 0.4 points in the last six months."
—Jim O'Sullivan, chief U.S. economist, High Frequency Economics

"The overall picture is that the labor market remains lackluster. If this state of affairs continues throughout most of this year, as we expect, then it is hard to see the Fed dialing back or stopping its [quantitative-easing] purchases as some officials currently envisage."
—Paul Ashworth, chief U.S. economist, Capital Economics

Today's Job Openings and Labor Turnover Survey (JOLTS) report from the U.S. Bureau of Labor Statistics (BLS) did little to change that impression.

The interest in the Fed's reaction, always acute given the employment half of the Fed's dual mandate from Congress, has been heightened since the Federal Open Market Committee (FOMC) announced, first in September, that it will continue its asset-purchase programs as long as "the labor market does not improve substantially." But what constitutes substantial improvement is a matter of some art, as Fed Chairman Ben Bernanke made clear at his press conference following the December meeting:

In assessing the extent of progress, the Committee will be evaluating a range of labor market indicators, including the unemployment rate, payroll employment, hours worked, and labor force participation, among others. Because increases in demand and production are normally precursors to improvements in labor market conditions, we will also be looking carefully at the pace of economic activity more broadly.

A terrific gallery that includes "a range of labor market indicators" is available at the Calculated Risk blog—you might also check out the Cooley-Rupert Economic Snapshot—but here at the Atlanta Fed, we have been experimenting with our own method for summarizing the general state of the labor market. Though this project is very much a work in progress, the idea is to highlight variables that look at employer behavior, signals of employer and employee confidence, measures of labor resource utilization, and leading indicators of labor market conditions.

Here's how to read this chart: Think of each point on the inner orange circle as representing the value of each of our labor-conditions variables in the fourth quarter of 2009. Point A, therefore, would represent the value of "temporary help services employment" in 2009:IVQ, point B would be "payroll employment" in 2009:IVQ, and so on around the circle. (We've chosen 2009:IVQ as a benchmark because that's the last time we experienced two consecutive quarters of negative employment growth. You can thus think of 2009:IVQ as the quarter just before the beginning of the current "jobs recovery.")

The chart's outer dark-red circle represents the value of each of the labor-conditions variables in the first quarter of 2007—the beginning of the last recession, according to the National Bureau of Economic Research Business Cycle Dating Committee. Moving out from the inner orange circle to outer dark-red circle tracks the progress each variable makes from its value at the end of the recession (i.e. 2009:IVQ) toward its prerecession (i.e. 2007:IVQ) level. For example, being at point C today would mean initial claims for unemployment insurance have fallen by half relative to the amount they increased between 2007:IVQ and 2009:IVQ. ("Improvement," of course, involves lower numbers for bad things, like unemployment and initial claims, and higher numbers for good things, like payroll employment and hires.)

The chart tells a familiar, but not too happy, story. Only one of the variables in the collection of employer behavior, employee and employer confidence, and labor resource utilization categories has recovered even half the gap from its prerecession benchmark. The labor resource utilization variables look particularly bad, with one variable—marginally attached workers—actually getting worse over the recovery as a whole. On the brighter side, our leading-indicator variables are looking relatively strong, perhaps portending improvement ahead.

The interpretation of these spider charts comes with several caveats. First, a variable such as the level of payroll employment will eventually exceed its pre-recession level, and grow consistently over time as the population grows. A variable like "hiring plans"—which is the net percentage of firms in the National Federation of Independent Business survey expecting to hire employees in the next three months—cannot grow without bound. Thus, the charts by construction are about visualizing the transition to some fixed benchmark, not a device for monitoring labor markets over the long run.

Second, it is not obvious that 2007:IVQ levels are necessarily the best benchmarks for all (or even any) of the variables we are monitoring. For example, the demographics associated with the aging of the baby-boom generations have arguably slowed the long-term trend in employment growth, meaning that a return to pre-recession payroll jobs will be slow even in circumstance that we would want to characterize as a "substantially" improving labor market.

Finally, signs of labor market improvement sufficient to alter the pace of FOMC asset purchases may be more about momentum or steady progress than about the return to a specific target or threshold. In fact, this chart depicts signs of such progress over the past three years...

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Comments

This is neat. I assume for unemployment the axis runs reverse direction, i.e. we want to get to as low a level as before the recession. Is the same true for "work part time for economic reasons" and "temporary help services?"

This is a much-improved way of presenting economic performance for laypersons, and perhaps for many experts. Can you seek wider use of the spider charts? And, can they be made interactive so that one could take other data and have it instantly converted to a spider chart?

In looking at the "marginally attached workers" data, it lends support to former Assistant Treasury Secretary Neel Kashkari's recent comments that those out of work for 12+ months are essentially "unemployable".

Pictures are great but I think you have a scale and weight problem inherent in a spider diagram. The display, in my view, is a visual index but as we all know each element is not equal. Need a little work on this.

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January 07, 2013

Inflation versus Price-Level Targeting in Practice

In last Wednesday's Financial Times, Scott Sumner issued a familiar indictment of "modern central banking practice" for failing to adopt nominal gross domestic product (GDP) targets, for which he has been a major proponent. We have expressed doubts about nominal GDP targeting on several occasions—most recently a few posts back—so there is no need to rehash them. But this passage from Professor Sumner's article provoked our interest:

Inflation targeting also failed because it targeted the growth rate of prices, not the level. When prices fell in the U.S. in 2009, the Federal Reserve did not try to make up for that shortfall with above target inflation. Instead it followed a "let bygones be bygones" approach.

In principle, there is no reason why a central bank consistently pursuing an inflation target can't deliver the same outcomes as one that specifically and explicitly operates with a price-level target. Misses with respect to targeted inflation need not be biased in one direction or another if the central bank is truly delivering on an average inflation rate consistent with its stated objective.

So how does the Federal Reserve—with a stated 2-percent inflation objective—measure up against a price-level targeting standard? The answer to that question is not so straightforward because, by definition, a price-level target has to be measured relative to some starting point. To illustrate this concept, and to provide some sense of how the Fed would measure up relative to a hypothetical price-level objective, we constructed the following chart.

Consider the first point on the graph, corresponding to the year 1993. (We somewhat arbitrarily chose 1993 as roughly the beginning of an era in which the Fed, intentionally or not, began operating as if it had an implicit long-run inflation target of about 2 percent.) This point on the graph answers the following question:

By what percent would the actual level of the personal consumption expenditure price index differ from a price-level target that grew by 2 percent per year beginning in 1993?

The succeeding points in the chart answer that same question for the years 1994 through 2009.

Here's the story as we see it:

If you accept that the Fed, for all practical purposes, adopted a 2 percent inflation objective sometime in the early to mid-1990s, there arguably really isn't much material distinction between its inflation-targeting practices and what would have likely happened under a regime that targeted price-level growth at 2 percent per annum. The actual price level today differs by only about 0.5 to 1.5 percentage points from what would be implied by such a price-level target.

Hitting a single numerical target for the price level at any particular time is of course not realistic, so an operational price-level targeting regime would have to include a description of the bounds around the target that defines success with respect to the objective. Different people may have different views on that, but we would count being within 1.5 percentage points of the targeted value over a 20-year period as a clear victory.

If you date the hypothetical beginning of price-level targeting sometime in the first half of the 2000s, then the price level would have deviated above that implied by a price-level target by somewhat more. There certainly would be no case for easing to get back to the presumed price-level objective.

A price-level target would start to give a signal that easing is in order only if you choose the reference date for the target during the Great Recession—2008 or 2009.

We're generally sympathetic to the idea of price-level targeting, and we believe that an effective inflation-targeting regime would not "let bygones be bygones" in the long run. We also believe that the Federal Open Market Committee (FOMC) has effectively implemented the equivalent price-level target outcomes via its flexible inflation-targeting approach over the past 15 to 20 years (as suggested in point number 1 above).

In fact, the FOMC has found ample scope for stimulus in the context of that flexible inflation targeting approach (which honors the requirements of the Fed's dual mandate of price stability and maximum employment). We just don't think it is necessary or helpful to recalibrate an existing implicit price-level target by restarting history yesterday.

Comments

"Misses with respect to targeted inflation need not be biased in one direction or another if the central bank is truly delivering on an average inflation rate consistent with its stated objective."

is exactly equivalent to saying that a random walk is not biased up or down. That's certainly true, but it's also true that E(X[t+k] - X[t])^2 = k. When you target the first difference of the price level rather than the price level itself, the forecast error for the optimal forecast is going to be a random walk. You get much smaller forecast errors going out if you target the price level.

It's also a whole lot easier to explain to the public. If you say "we're going to target high inflation now because it was low earlier" that will sound fishy to most people. But if you put it as "The CPI is running below our target path recently, so we're going to bring it up to the target" it doesn't feel quite so much like you're trying to pull a fast one.

I wonder if you've seen the Mishkin and Woodford piece in the Wall Street Journal yesterday. There's still plenty of room in the NGDP level target bandwagon, but it's filling up fast!

I think the chart is deceptive. During most of this period, indeed until January 2012, when the Fed adopted an explicit inflation target, the perception was that the Fed was targeting core inflation. My impression is that the shape of this chart is driven mostly by oil prices (falling in the 1990's and rising in the mid 2000's, hence the chart's bulge in the intervening period), which would be irrelevant if the core PCE deflator, rather than the headline, were the target. According to my calculations, rather than, as this chart implies, having overshot the target relative to the early 2000's, we would be undershooting the target on a core PCE deflator basis. Comparing PCEPILFE (from FRED) for Nov 2012 to Nov 2003, I get an increase of 18.4%, compared to the 19.5% increase that would be implied by an annual increase of 2%.

Now, one might (though I think it would be a bad idea) choose the headline index as a price level target going forward, perhaps using January 2012 as a base date, since the perception since then has been that there is a headline target. But it makes no sense to apply that price level target retroactively to a period when the perception at the time was of a core target.

In any case, as I said, I think the headline PCE deflator is a bad price level target. If you're going to use a price level target (and I do think it would be better than an inflation target), then you don't want to use a price index that will be subject to shocks that are volatile but persistent. A one-time increase in the price of oil should not require a subsequent compensating decline in other prices to offset it (nor should a one-time decrease in the price of oil require a subsequent burst of inflation to offset it). Theoretical arguments would suggest using an index of sticky prices, but the core is a reasonable approximation.

I think Sumner's argument goes through pretty much unscathed if you think in terms of core prices.

You refer back to your previous post on NGDP level targeting, but fail to take note of the comments that respond to your concerns about it. Specifically, see the ones by Andy Harless and Gregor Bush. Would love to see your response to those ones. Do you have a response for them? I am listening if you have one.

In all the hooha about monetary policy (MP)targets and poor response from fiscal policy (FP), nobody has mentioned what fiscal policy should be targeting? Ideally, MP and FP should work together. Why not have FP targeting NGDP?

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January 02, 2013

What the FOMC Said: More Clarification

UC San Diego professor Jim Hamilton is in my opinion one of the blogosphere's best commentators on Fed policy, and his most recent post at Econbrowser has a nice, concise retrospective on U.S. monetary policy over the past four years. But in the nobody's perfect category, there is one bit that I think requires a correction:

At the most recent FOMC meeting, the Fed signaled that QE3 purchases will continue as long as the unemployment rate remains above 6.5% and inflation below 2.5%.

Actually, those thresholds apply to the period of time that the members of the Federal Open Market Committee (FOMC) currently expect the federal funds rate target to remain near its zero lower bound. They do not apply to the duration of the FOMC's asset-purchase programs.

Unlike the explicitly quantitative criteria associated with the Committee's forward guidance about the federal funds rate, which I will discuss in a moment, the criteria the Committee will use to make decisions about the pace and extent of its asset purchase program are qualitative; in particular, continuation of asset purchases is tied to our seeing substantial improvement in the outlook for the labor market. Because we expect to learn more over time about the efficacy and potential costs of asset purchases in the current economic context, we believe that qualitative guidance is more appropriate at this time.

The Chairman goes on to explicitly discuss the 6.5 percent/2.5 percent thresholds on the forward guidance regarding the funds rate, and he circles back to the distinction between that guidance and the "QE3 purchases":

It's worth noting that the goals of the FOMC's asset purchases and of its federal funds rate guidance are somewhat different. The goal of the asset purchase program is to increase the near-term momentum of the economy by fostering more-accommodative financial conditions, while the purpose of the rate guidance is to provide information about the future circumstances under which the Committee would contemplate reducing accommodation. I would emphasize that a decision by the Committee to end asset purchases, whenever that point is reached, would not be a turn to tighter policy. While in that circumstance the Committee would no longer be increasing policy accommodation, its policy stance would remain highly supportive of growth. Only at some later point would the Committee begin actually removing accommodation through rate increases. Moreover, as I have discussed today, the decisions to modify the asset purchase program and to undertake rate increases are tied to different criteria.

The separate moving pieces of interest rate policy and the Fed's asset purchase program are subtle, and I admit at times confusing. But as monetary policy moves forward, it is important to keep the distinctions front and center.

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